How to Trade Options Using VantagePoint and Trade Management

Option Contract Basic Value Options originally developed to hedge risk Call Options developed in 1973 Put Options developed in 1977 Option Purpose Hedge against commodity loss Reduce income fluctuation Options allows the trader to be extremely versatile Bullish Bearish Neutral Direction Indifferent Copyright 2016 Market Technologies, LLC. 3

Option Lingo 1 Option Contract is worth: Equity (Stocks) = 100 Shares Futures = 1 Future Contract LEAPS:(Long Term Anticipation Securities) Options that have an expiration period greater than 1 year Strike Price: The price at which an underlying stock can be purchased or sold Expiration Date (Expiry) The date of that Option Contract Expiration. Most Options Expire on the Saturday following the 3 rd Friday of each month In-the-Money (ITM) That portion of an option that has value if the contract were to expire At-the-Money (ATM) When an Option s Strike price is the same as the current price of the underlying security Out-the-Money (OTM) If there is no value should an Option expire at that time Copyright 2016 Market Technologies, LLC. 4

Option Lingo Exercise: Option owner (Holder) who invokes their right to buy or sell is said to Exercise their Option Contract [note that Call Option Holders exercise their right to buy; Put Option Holders exercise their right to sell] Assignment: When the Option Holder Exercises their rights, the Option Writer is then Assigned American Style Options: These options can be exercised any time by the option Holder [most options are American Style]. European Style Options: These are options that can only be exercised upon contract expiration. [examples include options on stock indexes like the S&P 500 [SPX] or the Russell 2000 [RUT] Parity: An option is said to be trading at Parity with the underlying security if it is trading for its intrinsic value Open Interest: Unlike stocks where there are a fixed number of shares traded, option trading involves the creation of option contracts. Open Interest tells you the number of option contracts currently open. Copyright 2016 Market Technologies, LLC. 6

Participants in the Option Markets Buyers of Calls Call Option Holder Sellers of Calls Call Option Writer Buyers of Puts Put Option Holder Sellers of Puts Put Option Writer Copyright 2016 Market Technologies, LLC. 7

Options Basics Only 2 Option trade positions you can take Opening Position (Buy to open, Sell to open) Closing Position (Buy to close, Sell to close) Expressed as BTO, BTC, STO, STC ROI example using Stock vs. Options XYZ Company @ $50.00 per share Owning Stock Using an Option Purchased 100 shares = $5,000 Purchased 1 Call Option at $4.00 = $400 Risk = $5,000 Risk = $400 Stock Increases in Value by $2.00 per share Stock profit = $2 or 4% ROI Option Value = $4.50 = %12.50 Copyright 2016 Market Technologies, LLC. 8

Option Review Long Call Right to buy Expectation is Bullish Debit Trade (pay to play) Buy to Open (BTO) Short Call Obligation to sell Expectation is Bearish Credit Trade (paid to play) Sell to Open (STO) Long Put Right to sell Expectation is Bearish Debit Trade (pay to play) Buy to Open (BTO) Short Put Obligation to buy Expectation is Bullish Credit Trade (paid to play) Sell to Open (STO) Copyright 2016 Market Technologies, LLC. 9

Option Pricing Theory Option Pricing is based upon a mathematical formula define in the Black-Scholes Model (and others) Option Price is composed to 2 components: 1. Intrinsic Value 2. Extrinsic Value Option Price Components XYZ Stock = $50 per share Call Option with a strike price of 45 due to expire in 3 months = $8.50 per contact Intrinsic Value = $5.00 Extrinsic Value = $3.50 Extrisnic Value Components Time Decay Volatility Interest Rates Copyright 2016 Market Technologies, LLC. 10

Option P&L Graph Bearish Positions Short Call Profit +$0 Short Call Obligation to sell Expectation is Bearish Credit Trade (paid to play) $0 $20 $40 $60 $80 Loss -$0 Copyright 2016 Market Technologies, LLC. 15

Option P&L Graph Bullish Positions Short Put +$0 Profit Loss $0 -$0 $20 $40 $60 $80 Short Put Obligation to buy Expectation is Bullish Credit Trade (paid to play) Copyright 2016 Market Technologies, LLC. 17

Option Greeks What are They? Statistical references that are calculated by the Option Pricing Model Measurements of an individual option s sensitivities to the changes in the component variables that effect option pricing 1. Underlying price 2. (K) Strike price 3. Time to Expiration 4. Volatility 5. Dividends 6. Interest Rates Used to determine risk in an individual option or the entire portfolio Copyright 2016 Market Technologies, LLC. 18

Option Greeks Delta (Δ) Delta (Δ) can be defined 4 ways: 1. The rate of change of an option value relative to a change in the underlying 2. The derivative of the graph of an option value in relation to the stock price 3. The equivalent of the underlying shares represented by an option position (Hedge Ratio) 4. The estimate of the likelihood of an option expiring ITM Most watched and common Greek In-the-Money (ITM) options have higher Delta Out-of-the-Money (OTM) options have lower Delta At-the-Money (ATM) options have medium Delta Copyright 2016 Market Technologies, LLC. 19

Option Greeks Delta (Δ) Definition 1 Rate of Change This is the most used definition of Delta It defines the size of the option price move per $1 move in the underlying price Copyright 2016 Market Technologies, LLC. 20

Option Greeks Delta (Δ) Underlying Price Movement Long Calls UNDERLYING STOCK PRICE MOVE Stock Price $60.00 $61.00 Call Value 3.00 3.50 Delta 0.50 0.54 UNDERLYING STOCK PRICE MOVE Stock Price $60.00 $59.00 Call Value 3.00 2.50 Delta 0.50 0.46 Copyright 2016 Market Technologies, LLC. 21

Option Greeks Delta (Δ) Underlying Price Movement Long Puts UNDERLYING STOCK PRICE MOVE Stock Price $60.00 $61.00 Put Value 2.25 1.85 Delta -0.40-0.36 UNDERLYING STOCK PRICE MOVE Stock Price $60.00 $59.00 Put Value 2.25 2.65 Delta -0.40-0.44 Copyright 2016 Market Technologies, LLC. 22

Option Greeks Delta (Δ) Definition 2 Derivative of option price Mathematically, for any given point on graph below the derivative will show the rate of change of the option price CALL VALUE Call Price STOCK PRICE Stock Price Copyright 2016 Market Technologies, LLC. 23

Option Greeks Delta (Δ) Definition 3 Underlying shares equivalent (Hedge Ratio) In absolute terms the Delta of an option is between 0.00 1.00 A Call with a delta of.60 means that a dollar rise in the stock price causes the option price to go up $0.60 1 Contract = 100 shares to = $60.00 =60 shares If you Buy to Open 5 contracts with a 0.43 Delta you have the equivalent of 215 Deltas (5 x.43 x 100) The share equivalent is 215 shares Copyright 2016 Market Technologies, LLC. 24

Option Greeks Delta (Δ) Definition 4 Likelihood of expiring ITM It is not exactly/mathematically precise, but the option delta projects the probability of the option finishing ITM A option with a delta of.60 = 60% probability of ITM An option with a delta of.34 34% probability of ITM Copyright 2016 Market Technologies, LLC. 25

Option Greeks Delta (Δ) Option deltas are not constant and are based upon the dynamic inputs of the pricing model stock price, time to expiration, volatility Call and Put pairs the delta s are closely correlated As a general rule, the absolute value of a call delta + the absolute value of the put delta add up close to 1.00 The reason is the mathematical relationship between Put-Call Parity (we explain this in more detail in our Option Synthetics video) Options ITM have higher delta s Options ATM have delta s approx.50 Options OTM have delta s less than.50 Copyright 2016 Market Technologies, LLC. 26

Option Greeks Delta (Δ) Effect of Time on Delta The more time left until an option expires the less certain it is whether the option will be ITM or OTM Therefore, the Delta s of both ITM & OTM options reflect that uncertainty ITM Option Delta s increase as expiration approaches OTM Option Delta s decrease as expiration approaches Effect of Volatility on Delta As Volatility increases OTM Delta s increase & ITM Delta s decrease As Volatility decreases OTM Delta s decrease & ITM Delta s increase Copyright 2016 Market Technologies, LLC. 27

Option Greeks Gamma (Г) Gamma (Г) can be defined: 1. Gamma is the rate of change of an option s delta given a change in the price of the underlying security 2. Gamma is stated in terms of deltas per dollar move Gamma is the second derivative of the graph of the option price relative to the stock price Gamma (like Delta) is not constant ITM & OTM options have lower gamma ATM options have higher gamma Copyright 2016 Market Technologies, LLC. 28

Option Greeks Gamma (Г) Underlying Price Movement Long Calls UNDERLYING STOCK PRICE MOVE Stock Price $60.00 $61.00 $62.00 Call Value 3.00 3.50 4.04 Delta 0.50 0.54 0.58 Gamma 0.04 0.04 0.04 UNDERLYING STOCK PRICE MOVE Stock Price $60.00 $59.00 $58.00 Call Value 3.00 2.50 2.04 Delta 0.50 0.46 0.42 Gamma 0.04 0.04 0.04 Copyright 2016 Market Technologies, LLC. 29

Option Greeks Gamma (Г) Underlying Price Movement Long Puts UNDERLYING STOCK PRICE MOVE Stock Price $60.00 $61.00 $62.00 Put Value 2.25 1.85 1.49 Delta -0.40-0.36-0.32 Gamma 0.04 0.04 0.04 UNDERLYING STOCK PRICE MOVE Stock Price $60.00 $59.00 $58.00 Put Value 2.25 2.65 3.09 Delta -0.40-0.44-0.48 Gamma 0.04 0.04 0.04 Copyright 2016 Market Technologies, LLC. 30

Option Greeks Gamma (Г) When you buy (Long) options you acquire positive gamma Positive gamma helps you causes options to gain value at a faster rate and lose value at a slower rate When you sell (Short) options you acquire negative gamma Negative gamma works against you as a short seller it will accelerate your losses Copyright 2016 Market Technologies, LLC. 31

Option Greeks Theta (θ) Option Prices/value are broken into 2 components; Intrinsic & Extrinsic Intrinsic is easily measurable [the ITM part of premium] Extrinsic value is considered the time value [the premium paid over parity for the option] The decay in option value because of time passage is called time decay or Theta in the Greeks Long Options = Negative Theta Short Options = Positive Theta If interest rates are above zero then call theta is higher than put theta ATM options have highest theta Only the option s extrinsic value is subject to Theta Higher Volatility also increases an Options premiums thus also increasing Theta decay Copyright 2016 Market Technologies, LLC. 32

Option Greeks - Vega Vega measures the rate of change of an options theoretical value relative to a change in Implied Volatility (IV) This is the value that, when entered into an option pricing model returns the option s theoretical value When IV rises or falls, option prices rise or fall in line with it (Vega is the rate of this change) A Call (Put) with the same expiration month & the same strike on the same underlying will have the same Vega value as its corresponding Put (Call) Long options have Positive Vega/Short options have Negative Vega The higher the time premium, the higher the Vega ATM options have the highest Vega since Vega only effects extrinsic value If an option is valued at 1.68 and it s Vega is.06 then the following price change can occur with a change in Volatility Volatility increases from 22% to 25%; Option value increases by.18 to 1.86 (10.7% increase in value) Volatility decreases from 45% to 28%; Option value decreases by 1.02 to.66 (60.7% decrease in value) Copyright 2016 Market Technologies, LLC. 34

Option Volatility Historical Volatility (HV) [Also known as Statistical or Realized Volatility] Is defined as the Annualized Standard Deviation of daily returns HV is a simple measure of how volatile the price movement of a security has been during a certain period of time Example: (Both Stock A and Stock B are trading around 100 per share) Stock A moves up/down $5 to $7 per share Stock B moves up/down $1 to $2 per share Stock A has tended to move more than Stock B as a percentage of price without regard to direction Therefore Stock A is more volatile than Stock B Therefore Stock A has a higher HV than Stock B So HV is a measure of how volatile the price movement of a security has been during a certain period of time But exactly how much higher is Stock A s HV than Stock B s HV? Well, first Volatility of any given stock is measured in terms of Standard Deviation Copyright 2016 Market Technologies, LLC. 35

Option Volatility Standard Deviation Standard Deviation [Std. Dev] (σ or sigma is the Greek symbol) Is a mathematical calculation that measures the dispersion of data from a mean value The mean is the average stock price over a certain period of time And the further from the mean the dispersion of the occurrences (daily close) was during the period, the greater the Standard Deviation The most common time frame is the past 20 days (weekends do not count) to calculate HV And understanding the timeframe in question is important to understanding what the output represents Standard Deviation is stated as a percentage move in the price of an asset. For example, Stock 1 is at $100 per share has a standard deviation of 15% (when you are given a standard deviation measure, it is always assumed to be a Std. Dev of 1) then on an annualized basis the stock can move up to $115 or down to $85 per share So on any given stock that has a Std. Dev of 15% is considered more volatile than a stock that has a Std. Dev of 6% The graph of the data that represents the closing price dispersion of any given stock which is reflected in its 1 Std. Dev of movement is called a distribution curve. Copyright 2016 Market Technologies, LLC. 36

Random Walk Theory * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * 68% 95% Std Dev tells us not only how fast the distribution spreads out; -it tells us about the probability of a ball ending up in a specific trough...it measures the dispersion of data from a mean value Copyright 2016 Market Technologies, LLC. 37

Option Greeks Rho (ρ) Rho is the rate of change in an option value relative to a change in the interest rate If interest rates go up = Call Value rises If interest rates go down = Call Value decreases Usually the least followed Greek since it takes a very large move in interest rates to effect Rho to an extinct that moves the option value mostly in Leaps is where Rho can be a factor For example, a Call with a Rho of 0.12 will increase $0.12 if interest rates rise a full point (100 basis points) Copyright 2016 Market Technologies, LLC. 39

Dividends Effect on Options Dividends paid decrease Call value & increase Put value 4 Key dates you must be aware of: 1) Declaration date: when company formally declares a dividend 2) Ex-Dividend date: 2 days before the record date [due to stock settlement] 3) Record date: date of record for who gets the dividend payment 4) Payable date: date of payment ABC Corp announces on March 31 st (declaration date) it will pay a $0.25 dividend to shareholders of record on April 3 rd (the record date) payable on April 23 rd (the payable date)...the market participates wishing to get the dividend must own the stock on April 1 st (the ex-dividend date). Option holders or writers do not receive or pay dividends Copyright 2016 Market Technologies, LLC. 40

Dividends Effect on Options Call Value with $0.10 Dividend Price 61 Strike 60 Days to Expiry 528 Volatility 25.5% Interest 5.00% Call Value 9.65 Put Value with $0.10 Dividend Price 61 Strike 60 Days to Expiry 528 Volatility 25.5% Interest 5.00% Put Value 5.42 Call Value with $0.50 Dividend Price 61 Strike 60 Days to Expiry 528 Volatility 25.5% Interest 5.00% Call Value 8.13 Put Value with $0.50 Dividend Price 61 Strike 60 Days to Expiry 528 Volatility 25.5% Interest 5.00% Put Value 6.08 Copyright 2016 Market Technologies, LLC. 41

Greek Effects on the Underlying If You Are Your Delta Position is Your Gamma Position is Your Theta Position is Your Vega Position is Long Stock Positive 0 0 0 Short Stock Negative 0 0 0 Long Calls Positive Positive Negative Positive Short Calls Negative Negative Positive Negative Long Puts Negative Positive Negative Positive Short Puts Positive Negative Positive Negative Copyright 2016 Market Technologies, LLC. 42

Greek Effects on the Underlying If Your Greek Postion is. If your Delta Postion is positive If your Delta Position is negative If your Gamma position is positive If your Gamma position is negative If your Theta position is positive If your Theta position is negative If your Vega position is positive If your Vega position is negative If your Rho position is positive If your Rhoa position is negative You Want Your Stock Postion to. Rise in Price Fall in Price Move very swiftly, regardless of the direction Move very slowly, regardless of the direction The passage of time will generally increase your value The passage of time will generally decrease your value You want volatility to rise which raises your value You want volatility to fall which raises your value You want interest rates to rise which will increase value You want interest rates to fall which will increase value Copyright 2016 Market Technologies, LLC. 43

Trade Selection Strategy Checklist 1. Security Selection Process 2. What is your current bias a. Neutral b. Mildly Bullish c. Strongly Bullish d. Mildly Bearish e. Strongly Bearish f. Unknown (Breakouts; up or down) and Volatility Trades 3. What is the magnitude of the forecasted move 4. What is the timeframe of the forecasted move 5. Is there a Trigger price for the move 6. What is the support & resistant for the security 7. How will I know if my original bias is wrong during the trade 8. What is the current IV and HV of the security 9. What is your current Risk Appetite a. Position Size b. Primary Exit Point (PE) c. Secondary Exit Point (SE) d. Trade Stops/taking profits & losses 10. Trade Objectives 1. Income 2. Downsize Protection 3. Revenue Gain (+20%) Copyright 2016 Market Technologies, LLC. 44

Description Objective Trade Outlook Trade Rationale Composition Vertical Spreads Strategy Overviews Vertical Spreads are 2 legged option strategies designed to play either a bullish or bearish bias with either Calls or Puts in the same contract month. Two major Vertical Spread Types: Debit Spreads where you pay to play meaning your account is debited for the cost of the trade since you are long the more expensive option and short the less expense option in the same month and Credit Spreads where you get paid to play meaning you are shorting the higher priced option contract and going long the lower priced contract. Your goal is to have the price action move to and through the short option strike price. Trade is executed when your bias is Bullish using Call options or Bearish using Puts. Vertical Spreads are designed to capture a Bullish or Bearish Play while reducing the effect of delta on your overall option position and enhancing your odds of success. Typical returns can be anywhere from 20% to well over 400% depending upon strike selection. All Calls or all Puts in the same contract month at different strikes Copyright 2016 Market Technologies, LLC. 48

1) Bull Call Spread Vertical Spreads Four Types Vertical Debit Spread or just Debit Spread Vertical Bull Spread or just Bull Spread 2) Bear Call Spread Vertical Credit Spread or just Credit Spread Vertical Bear Spread or just Bear Spread 3) Bear Put Spread Vertical Debit Spread or just Debit Spread Vertical Bear Spread or just Bear Spread 4) Bull Put Spread Vertical Credit Spread or just Credit Spread Vertical Bull Spread or just Bull Spread Copyright 2016 Market Technologies, LLC. 49

Vertical Spreads Strategy Highlights Directional Bias Risk Reward Option Strategies Bullish Bearish Sideways Limited Unlimited Limited Unlimited 1 Bull Put Spread XX XX XX 2 Bear Call Spread 3 Bull Call Spread 4 Bear Put Spread Copyright 2016 Market Technologies, LLC. 50

Vertical Spreads Strategy Highlights Directional Bias Risk Reward Option Strategies Bullish Bearish Sideways Limited Unlimited Limited Unlimited 1 Bull Put Spread XX XX XX 2 Bear Call Spread XX XX XX 3 Bull Call Spread 4 Bear Put Spread Copyright 2016 Market Technologies, LLC. 51

Vertical Spreads Strategy Highlights Directional Bias Risk Reward Option Strategies Bullish Bearish Sideways Limited Unlimited Limited Unlimited 1 Bull Put Spread XX XX XX 2 Bear Call Spread XX XX XX 3 Bull Call Spread XX XX XX 4 Bear Put Spread Copyright 2016 Market Technologies, LLC. 52

Vertical Spreads Strategy Highlights Directional Bias Risk Reward Option Strategies Bullish Bearish Sideways Limited Unlimited Limited Unlimited 1 Bull Put Spread XX XX XX 2 Bear Call Spread XX XX XX 3 Bull Call Spread XX XX XX 4 Bear Put Spread XX XX XX Copyright 2016 Market Technologies, LLC. 53

Vertical Spreads Strategy Highlights Spread Type Trade Rationale Construction Bias Bull Call Spread Bear Call Spread Bear Put Spread Bull Put Spread Reduces trade BE and costs of a bullish option trade plus reduces delta and theta effect BTO lower strike Call STO higher strike Call Creates premium based strategy STO lower strike Call whereby you are using theta BTO higher strike Call decay to your advantage Raises trade BE and costs of a bearish option trade plus reduces delta and theta effect BTO higher strike Put STO lower strike Put Creates premium based strategy STO higher strike Put whereby you are using theta BTO lower strike Put decay to your advantage Debit Credit Bullish Debit Debit Bearish Credit Max Risk Max Reward Breakeven Diff in Strikes minus Credit Bearish Debit Debit Bullish Credit Diff in Strikes minus Credit Diff between strikes minus Debit Credit Diff between strikes minus Debit Credit Lower Strike + Debit Lower Strike + Credit Higher Strike - Debit Higher Strike - Credit Copyright 2016 Market Technologies, LLC. 54

Vertical Bull Spreads Bullish Vertical Spreads can be constructed using either Calls or Puts Bull Call Spread Construction [Debit Spread] Bull Put Spread Construction [Credit Spread] These are synthetically equivalent if same expiry/same strike Bull Call Spread CALLS STRIKES PUTS 100 +1 105-1 110 Bull Put Spread CALLS STRIKES PUTS 100 105 +1 110-1 Copyright 2016 Market Technologies, LLC. 55

Bullish Vertical Spreads Risks & Rewards Bull Call Spread Max Loss = Debit Paid for the Spread Max Gain = Difference between K s minus price paid Breakeven = Lower K + price paid for spread Bull Put Spread Max Loss = Difference between K s less Credit Max Gain = Credit Received Breakeven = Higher K Credit Received Copyright 2016 Market Technologies, LLC. 56

Vertical Bear Spreads Bearish Vertical Spreads can be constructed using either Calls or Puts Bear Call Spread Construction [Credit Spread] Bear Put Spread Construction [Debit Spread] These are synthetically equivalent if same expiry/same strikes Bear Call Spread CALLS STRIKES PUTS 100-1 105 +1 110 Bear Put Spread CALLS STRIKES PUTS 100 105-1 110 +1 Copyright 2016 Market Technologies, LLC. 57

Bear Call Spread Vertical Bear Spreads Risks & Rewards Max Loss = Difference between K s less Credit Max Gain = Credit Received Breakeven = Lower K + Credit Received Bear Put Spread Max Loss = Debit Paid for the Spread Max Gain = Difference between K s minus price paid Breakeven = Higher K - price paid for spread Copyright 2016 Market Technologies, LLC. 58

Vertical Option Spread Summary Designed to reduce risk while holding an option position Delta in the position is reduced due to short call position Can generate very good returns in excess of 25% while also allowing for stock pullback (by using ITM Spreads) The stock can make a smaller move in your direction and you will make more money than by holding a single leg option or put position Copyright 2016 Market Technologies, LLC. 59